Note: While as ever this article is not personal investment advice, know that do I own a few shares in Seedrs. Also if you follow my links to Seedrs and try their platform, you can get a £50 investment credit and I may receive a small marketing fee.
Over the past 15 years, advances in technology – smartphones, Cloud-based storage and processing, and low-cost software development – have enabled entrepreneurs to scale up massive companies with little outside capital.
In 2014 Facebook paid almost $20 billion for WhatsApp, a messaging service only five-years old.
WhatsApp had just 55 employees at that time, and most of the momentum that took it to 400 million users came from seed capital1, and some later venture capital (VC) funding.
That was enough to grow it to a valuation of c. $20 billion!
WhatsApp is not unique. The current implied valuations of unlisted start-ups like Uber and AirBnB make the billions Facebook paid for WhatsApp seem stingy. These disruptive giants – again just a few years old – have made their early seed investors rich and delivered stellar returns for VC firms.
Previously it would have taken a couple of decades for a new industry to grow into the $20-billion deal bracket.
Along the way, at least some of the leading companies would probably have floated on the stock market.
But these new behemoths achieved scale without us ordinary stock market investors getting a look in.
It’s not unprecedented, but it is a conundrum.
When capitalists don’t need capital
Of course the initial money for startups has always come from friends, family, and angels (wealthy individuals).
Later and more substantial financing comes from VC funds (especially in the US tech sector) and strategic partners such as big firms in adjacent sectors.
But most founders with global ambitions previously had to tap the public stock markets for the booster fuel needed to achieve multinational escape velocity.
A wider range of funds – and even ordinary punters – could then buy into these still relatively small firms when they floated on the stock market, via an IPO.
And after that, anyone could buy their shares.
In today’s low-capital startup world, however – where it takes takes barely a Love Island villa’s worth of talent to create companies worth billions – we might wonder whether we’re missing out on growth that has previously made up part of the reassuring historical returns seen from owning equities.
Most startups amount to nothing, but the best become the giants of tomorrow. They grow from small winners into middle-sized companies, and some into stock market titans.
True, Uber and AirBnB will probably float some day. (If only so their employees can easily offload the shares they’ve earned.)
But given the vast scale they’ve already achieved as private companies, how much growth will be left for ordinary folk when they do?
I don’t know the answer, but I think it’s worth asking – especially given how important the tech sector has been in driving global market returns.
Imagine if the next wave of Amazons, Googles, Microsofts, Apples, and Netflixes all came to the market years later – and far bigger – than they did?
Trillions in valuation growth might never be seen by stock market investors.
The best VC funds don’t want our money, either
If you think this is a problem – I’m undecided, but wary – then the obvious answer is to invest in private (i.e. unlisted) companies for yourself.
This has long been possible, but it’s not a straightforwardly good decision.
Studies paint a mixed picture about the returns from venture capital as an asset class, and it’s hard to get clear data.
Industry promotional material – such as this overview from Barclays – tends to be short on return information.
The picture is complicated by how venture capital goes through feast and famine, wildly influencing the performance of funds of different vintages that raised money at different times.
For instance the FT reported in 2017 that a representative subset of European VC funds that took money at the height of the dotcom boom in 2000 on average paid back just 39% of the money put into them!
Some did much better. But this only raises the perennial question of knowing which funds to put money into.
And while the UK and European VC sector is becoming more established, the biggest and best funds are still based on the West Coast of the US.
These US funds get the pick of company founders and ideas. In the hit-driven game of venture capital, that’s crucial.
US funds would also argue they’re best-placed to help the startups they invest in via their own long-established networks – by introducing them to managerial talent, other investors, potential acquisitions and so on – and so creating a virtuous circle.
You might decide the solution is to invest in these US funds, but the elite ones are usually closed to all but the richest investors and institutions – and some even to them.
Yet the return from these top outfits will skew higher any return figures you see from the VC asset class – even though oiks like us can’t buy into them!
Ways to invest in venture capital
For these reasons and others (notably a lack of liquidity and high fees) most of the writers we rate – Hale, Kroijer, Swensen, and the lazy portfolio creators – do not see a place for VC in everyday investor portfolios.
But what if you disagree?
There are ways to put money to work in private companies if you’re keen. You don’t even have to move to San Fransisco and fill your wardrobe with chinos.
However all come with challenges – and you’ll need to do a lot of research.
Here’s a summary of the main routes you could explore.
Invest via venture capital funds
The venture capital firms are out there – there’s even a growing seed investing scene in London – but whether you can judge the best funds in advance – or as I say put money into them – is extremely debatable. VC investing is brutal, at least for the investors. (The managers enjoy some fees either way.) If you’re a high net wealth type, you’ll find private banks may include VC (or at least private equity) funds in their managed portfolios. Such a relationship might get you access into better funds that would otherwise be unavailable – but you’ll need to don your shark-proof armour!
Investment trusts
There are a bunch of investment trusts that operate in the unlisted space. The majority are private equity rather than VC-focussed. This means your money will be funding things like management buy-outs, expansion at more established companies (including debt raises), and perhaps buying into a portfolio of companies that your trust owns outright. You’ll need to dig deeply to look for trusts with a growth perspective, if that’s your bag. You could even look at something like Neil Woodford’s Patient Capital Trust, or other idiosyncratic trusts that have a relatively high allocation in unlisted firms. Expect a rocky ride – with market conditions and the business cycle playing a big role – and understand that failures happen early in VC investing, so it can look pretty dark before any dawn.
Venture Capital Trusts (VCTs)
Going by the label on the tin, you’d think your hunt would stop here. VCTs come with tax breaks (albeit watered down in recent years) and many do put significant sums into start-up firms. However as a class they are definitely not all focused on high-growth minnows.2 VCTs mostly aim to return money to shareholders via relatively high (and tax-free) dividends rather than in multi-bagging your initial investment. Their high fees make are also a big problem, as I’ve discussed before. I’ve wealthy chums who’ve maxed out their SIPPs and ISAs who love VCTs for the tax-free dividends, but for most of us these probably aren’t the venture capital vehicles we’re looking for.
Angel investing
It’s hard to get closer to the coal face of backing unlisted companies than to do a bank transfer to the founder of a start-up in exchange for a chunk of their shares. Perhaps you’ll even get a say in how the business develops. Results from angel investing will vary extravagantly, and cause your typical Monte Carlo simulator to reconsider its life choices before having a melt down. Angel investors run the gamut from the founders of hit companies like Skype to big fish in small provincial ponds who fancy co-owning a restaurant. Clearly, if you’re looking for the next globe-conquering Tinder or WhatsApp, don’t give money to your mate who wants to open a craft beer shop. The best book I’ve read on hunting for tech companies that might return 100x your money is Angel by Jason Calacanis.
Equity crowd funding
Not many of us can write the chunky cheques required to be an angel investor without jeapordising our future wealth. If you’ve got £5m to your name then perhaps it’s fine to stick £50,000 into several exciting moonshots to hang around with clever 20-something hipster coders. If you’ve only £50,000 in your ISAs and SIPPS, not so much.
Over the past few years, however, platforms such as Seedrs, Crowdcube, and Syndicate Room have addressed this issue by pooling often very small amounts of money from thousands of individual investors to put money into startups as a bloc.
It works, but there are issues.
In theory these platforms are democratizing venture capital and I applaud that on principle. (I even invested a little in Seedrs).
But in my experience the quality of both the companies listed on these platforms and the investors putting money into them is extraordinarily variable, to put it mildly. This is hugely risky investing, and as the space is so new there’s not return figures available that take into account all the future failures – or at least not figures I find thoroughly convincing.
For the record, Seedrs for instance has claimed a 12% internal rate of return across all-fundraisings on its platform – jumping to over 26% if potential tax breaks are taken into account.
I do judge Seedrs puts a superior cut of companies onto its platform, for what my observations are worth.
But the truth is we’ve not got a long-term to look at with these platforms yet, and barely a medium-term.
Worse, most individuals will likely discover they have a negative edge in assessing small startups. Crowd funding raises are invariably supported by scanty financial details and in a handful of cases what have seemed to me borderline fraudulent business plans. People still back them.
‘Adverse selection’ also looms large. Why are the founders coming to the great unwashed if they could get money from traditional VC funders? Perhaps because they’ve been turned down elsewhere?
On a brighter note you can often meet the founders in person (at least in London) which I believe is far more important with this kind of investing.
I also think there are companies for whom crowdfunding actually makes more sense than traditional fund raising, at least early on. I’m thinking of consumer-facing companies that may benefit from an army of shareholder-promoters.
There are also compelling tax breaks for investors putting money into firms that qualify for EIS and SEIS relief. Most of the tiny startups you’ll come across via fund raising do qualify.
Just remember that however good you are, many or maybe even most of these companies will eventually fail or near enough fail and you’ll lose the money you put into them. Much of that money can be offset by the tax reliefs, but not all of it.
The following graph is typical of the distributions of winners to losers you’ll see quoted:
(It’s based on US returns from professional VC investors, so if anything it is over-stating the chances of amateur angels striking it big.)
The aim of the game is to be in one or two of the few companies that may eventually break out of the crowdfunding morass to achieve ginormous scale. If you manage this it could make up for all your losers and then some.
Financial firms Monzo and Revolut and the brewer BrewDog have all delivered handsomely for early crowd funding investors. There will be others, but they’ll shine beyond a meteor storm of burnouts and crashes. (One irreverent blog specialises in tallying the frequent failures).
Investing in lots of companies rather than betting on half a dozen is probably the best strategy for trying to get a sliver of a future giant.
But I wouldn’t invest so much that it will make a big difference if you never strike gold. This is lottery ticket investing at its riskiest.
Innovation in venture capital investing
For all the downsides, I have put about 3.5% of my net worth into unlisted companies via crowdfunding platforms.
However I have several diverse reasons to get involved, beyond any returns. (Improving my investing chops, for example.)
I’d urge caution in allocating anything more than play money-sized allocations for even most active investors, let alone passive players.
Indeed there seems to be gap in enabling everyday investors to get exposure to venture capital – and to enjoying those generous tax reliefs – without digging through the business plans of hundreds of mostly doomed start-ups.
The Seedrs platform has recently made some interesting moves in this direction, though I do think its solutions raise new issues even as they address others.
Will they offer a way for passive investors to easily get exposure to start-up companies?
More on that next week – subscribe to ensure you see it!
- Seed capital is the first money that goes into starting a new business. [↩]
- In the past some VCTs even actively avoided VC-type investments as much as was possible within the rules, in order to offer limited life capital preservation vehicles that milked the tax breaks, though this has now been curbed. [↩]
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Hmm, bit quiet here.
Thank you – this was a very thoughtful piece on a controversial but fascinating subject. I haven’t read enough about it, partly because it feels like a crowded market where I would have no edge. But I do enjoy watching Silicon Valley!
Also thanks for the link to the blog – truly eye-opening, and I’m glad people like this are out there holding others to account.
VCTs will be interesting going forward now that the rules have changed, and they have to invest in more higher-risk, early-stage companies. In the past British Smaller Companies and Northern were pretty reliable, but I don’t know if their team will have the ability to adapt.
And you rightly mention Investment Trusts for unlisted investments – apart from Woodford, the obvious ones I suppose would be Scottish Mortgage and the new Baillie Gifford US Growth trust. The new Merian (what a weird brand name) Chrysalis trust I know little about. The Augmentum one doesn’t look too bad, and I like the RCP connection.
Overall though, I am torn about the fact that much VC is unavailable to retail investors. On the one hand it feels unfair to deny people things, but on the other, when you see what people do with spreadbetting and FX, I think it’s better to keep some things out of people’s reach! As you say, VC stuff like this is very much lottery ticket stuff.
Thanks again.
If anyone with deep pockets fancies it then we’re doing a series A funding round. Rhino enterprises is a unicorn if ever I saw one!
I think tax advantages skew vc so much that it can only be realistically viable for people who have maxed out all other tax wrappers
@tom — Thanks, I was wondering if I’d accidentally insulted everyone’s mother. But then I relaxed as I remembered I hadn’t had three drinks quickly but no food yet at a quiet dinner party with my ex’s friends, where that kind of thing happened with the regularity of a French rom com. 😉
I’m not sure I’d put spreadbetting and FX in the same category as investing in VC through a legitimate pooled fund. VC is more likely to be a mediocre result than a wipeout (let alone the leverage you see in spreadbetting!) It’s true that crowd funding into individual companies could decimate the bank account of a credulous, over-confident, or foolish investor, but the process is pretty laborious so they’d at least have some cooling off time.
On ‘edge’, one reason I personally stared exploring the space is I thought it might be easier to find/deploy edge than in the public markets. Again, especially for individual mini-angel investing, the market is opaque, illiquid, and populated with participants who seem poorly-equipped to make great decisions. But perhaps I seem the same to them! I also think personal /sector knowledge is possibly more valuable in this sort of VC investing. You can get directly involved — even just by sharing a useful contact or evangalizing a product you’ve invested in and believe in when it still makes a difference. I find it’s also more rewarding, personally, to see my capital going directly into a new business that’s using it, rather than to another investor.
Besides the many issues in the article and the lack of straightforward market access, another major problem with VC right now is lots of capital and high valuations. In retrospect, even if moves to broaden the base of investors are well-founded, it may prove to have been a bad time to get involved anyway, although of course there’ll always be a few winners.
Most people can probably safely ignore the space entirely, but I believe there’s something here for the right kind of investor.
The last time I had a confab with An Entrepreneur his plan was to plunge into alternative energy. Ignoring my quip about subsidy farming he ploughed on, keen to pick my brains. It turned out that he couldn’t distinguish wave power from tidal power.
We could all raise money by pretending to be entrepreneurs, and then somehow our ventures fail (debt we owe ourselves perhaps?) – how are frauds filtered out effectively? What guarantees are there of actual ownership of a real equity?
@TI – Good post on a topic dear to my heart. Thank you.
I have quite a bit of experience in ‘angel’ investing and thankfully it has worked quite well for me, but even among the experienced angels I know I have been lucky.
I would add a few observations to your piece:
1) Liquidity. The big ‘catch’ with angel investing is the lack of liquidity. You should expect to have zero ability to control your Sell. Most Sells, especially the 50x ones, come after many years – and potentially a divorce or two. Seedrs is noteworthy here for taking steps to allow ‘secondary’ markets i.e. the ability for you to buy/sell existing angel shareholdings off each other.
2) Adverse selection on crowd platforms. As somebody who knows the venture ecosystem a bit, I would add that the businesses on the crowd platforms are usually ones that the ‘professional’ venture investors have passed on. Crowd platforms usually get the dregs. Even when Monzo et al. use the crowd the share class on offer may be a very junior/inferior version with few rights, compared to what the professionals buy.
3) Value add. A lot of ‘angel’ investing is on the basis of the angels being able to help. Hence the term. This doesn’t happen with crowd platforms. A big plus of investing directly is to be able to have a direct relationship with the top team and to be able to influence/help/advise/learn together.
4) Tracking. A trick I missed for the first few years… I find it extremely useful to track the investments in one place. It is very easy, especially for direct investments, to forget what you paid, what % ownership you have, etc. And to misjudge your returns. Ideally get into a rhythm where every time you wire money / make an investment it goes into a spreadsheet, and every time you receive a liquidation (if that ever happens, which it may never do) you pull out that spreadsheet.
As you can tell I am not a big fan of the crowd platforms!
@FireVLondon — Cheers for thoughts, which of course I concur with entirely. (I have counted every penny in, both pre-and post- tax relief, as well as other details. I also up-rate my estimated valuations in a separate column, based on follow-ons, but I don’t adjust value in my master sheet until demises (none yet touchwood!) or exits. 🙂 )
As for point (4), yes, they’re a bit clunky. I’ve had long conversation with two of the major platforms recently about tracking — both in terms of making the tax stuff simpler (there is a new digital certificate format that will help) and also as you say better mimicking how traditional brokers summarize your holdings. They do have roadmaps and the two big ones also have fresh funding, so fingers crossed.
It’s not really their fault that different platforms have different companies though, so I think they’ll sadly always be some silo-ing (unless a big consolidation?).
Great post, thanks @TI for bringing this to my attention.
I’m in, and I know, I know – my name’s wrong. But I’m mainly passive invested but occasionally I slip the leash and cross over to the dark side.
It’s timely too as I was recently asked if I could invest in a SEIS company, so I checked with my accountant what the tax benefits were, and if you pay high income tax rates and capital gains tax, as I do, then the tax benefits are quite substantial.
Thanks TI, interesting reading. I looked into EIS funds a couple of years back and it just felt like jumping into the shark pool still needing armbands. So I didn’t think it was for me. Nevertheless, they are attractive, not least because I have the feeling that sacrificing liquidity is a good way to boost long term returns. I’ve seen the inside of successful tech start-ups from the inside and it can be difficult to determine what differentiates the winners from the losers even with the inside track.
I dabbled a few years ago and was badly stung (investing in a pizza place, of all things) which collapsed due to the business partners falling out and confirmed the adage of putting the investment before the tax wheeze. There’s no doubt in my mind that it’s only for fun money and you need to have that, which unfortunately I don’t! There will no doubt be the odd gem out there but from when I looked most were just about viable businesses with utterly fanciful valuations. For the vast majority of people who want to have a wee punt I’d imagine a micro cap trust or fund would be much more appropriate.
Again this comes to the biggest struggle for investors (and bloggers i suppose) – the struggle with how boring prudent investing really is
I have mixed feelings about this area. There is strong risk that the tax tail wags the investment dog. As pension allowances have fallen, people have turned to the EIS/VCT sector as a substitute, so inflows have increased sharply. As a result, ever more dross is finding funding. Second, (as FvL mentions) there is the problem of liquidity. You haven’t made a penny until you’ve sold. I’ve had stuff go up 20x (based on later funding rounds) but still couldn’t sell, only for it to crash to precisely zero. Third, corporate governance, or rather the lack of it. Dodgy accounting, payments to consulting companies who happen to be owned by the CEO etc. End result, is that I’m small up vs. the S&P500 over the last 15 years. A few really big wins (mainly through investing via US based tech VCFs), many damp squibs, and a lot of failures. Take away one big win, however, and I’d be well down vs. S&P500.
To be honest what has worked far more consistently is EIS investments in “asset-rich” companies. As TI points out, some of this is an attempt to exploit EIS rules to find low risk investments to monetize tax relief. For me this started with renewables (solar/wind) but around 10 years ago, an IFA approached me with an idea … building crematoriums under EIS. The idea actually made huge sense. UK demographics means we need more of them. There tends to be limited competition. Margins, once built, are large and it’s not cyclical (people die in both boom and bust). I’ve bought into about 15 of between 2009 and 2013 and the’ve been great and I have no interest to divest of them. If for nothing else because once a quarter I can tell colleagues that “burnings are up 30% vs. plan”!
Sorry to have contributed to the idea that this is not an interesting topic. Bit busy this week.
But here are some thoughts on the risks based on experience. I have been involved in a corporate venture fund run/advised by experienced VCs, and I have helped prepare startups to pitch to VCs on the West Coast.
It is an absolutely brutal and Darwinian world. The chart shows the small number of winners out of those financed, but of course, an even bigger number never get financed at all (at least by VC’s). I tried to look up current figures, but all I could find was endless pages explaining how to create the perfect pitch deck, and mostly pitching for the business of creating your pitch.
From memory of about 10 years ago, a VC company I spoke to then was getting 400 approaches a week. A maximum of two of those would be seen by the decision makers, and then some would get funded. So there is a massive drop out of ideas before you get into actual financing, and then most investments don’t deliver.
One of the behaviours this drives is that your company has to look like a potential unicorn, and look like it could get there fast. There is no VC money for a good idea that would achieve modest returns or grow slowly and steadily. Perhaps the kind of company that the global economy needs?
Another is that the VC is looking for exit from the very beginning. Doesn’t matter what your plans are; the VC wants to know how big a multiple of the investment they can look forward to and when. Five years is the sort of exit point I hear VCs talking about. Not much time to ramp a company in most sectors, and not much time to build a solid company.
This in turn leads to founders who are planning for a quick exit themselves. The people with passion get steam-rollered and the cynical have an easier time. Again not necessarily the best thing for society or the economy.
Finally, VCs are herd animals for the most part. A couple of big failures and an entire sector can be off the list for years. In SF in 2017 I was told that nobody would have anything to do with PV. Not because they did not think that there was money to be made, but because it would take too long.
So I personally am not worried about whether or not I can get access to VC opportunities and the next unicorn. The model only really works for certain classes of economic activity, and not always the most productive/useful. Very smart and savvy business people get it wrong most of the time and the penalty for picking the wrong horse is not a reduction in the value of your investment, it is wipeout.
VC at the moment is the lottery for people with very deep pockets, ‘cos you need massively deep pockets to spread your bets.
Perhaps funding business through Funding Circle type operations is more of a fit for those without massive resources, and who knows may be more socially useful!
FvL has good sized pockets. I’m pretty convinced he wants to get into miltech. Rhinos are about as rare as unicorns. Opportunity of a lifetime. Let’s become ultra HNWIs together?
I think your conclusion this article didn’t interest readers from the dearth of comments jumped the gun.
I read it, was intrigued, but knew that this was sufficiently outside my ken that I would need more to have any chance of making intelligent comment. Which is very different from skipping it! More off-piste writing requested!
Good overview of the space, TI, thanks. Fascinated to read zx48k’s experience as well. Love the idea of ignoring flamboyant start-ups for tax-advantaged reprints of existing established industries. Innovation tax break indeed!
In my view, dealflow of quality opportunities is the issue. This means that there’s plenty of attention for poorer quality businesses on crowdfunding which despite a number of successes do look to me like not a home for smart money.
Which means unless you are going to spend a lot of time and money researching and meeting a lot of opportunities then it’s going to be hard to find suitable investments. Which is kinda where we came in: it’s tricky to get involved in this space.
Tracker, anyone?
Thanks for the excellent follow-up comments here all, most especially @ZXSpectrum and @old-eyes. There’s no doubt this is a marmite-y area, and as we all agree not something an investor *needs* to get involved in.
I was originally quite standoffish but over time got sucked in. Partly I had too much un-sheltered capital lying around earning nothing (this was before the flat purchase!) and little desire to add to my annual capital gain defusing woes. But more it was I want to specifically extend my investing skillset – and test any edge I may think I have – into a new area. Indeed on the latter point, the massive divergence in company quality and the insane variation in private VC investor sophistication is to me a draw not a downside, albeit I’d rather be seeing the great stuff the top VC funds on the West Coast see, not the weird bits and bobs that the crowd-funding platforms manage to wrangle up out of East London shared work spaces!
Time will tell – and I’ve certainly not invested in the same way I’d have invested if I was doing so professionally, where like everyone I’d only be looking for potential unicorns – but it’s already been a pretty rewarding experience, education-wise. I’ll see if I felt the price of that education was worth it in a few years, when more results have come in…
The follow-up post will be on a couple of pseudo-passive options from Seedrs. I think they’re interesting but equally need to be festooned with obvious caveats and risk warnings. More with part two!
Not much to add but just wanted to chip in with a massive “thanks” for posting these sort of posts, including your more recent one on the new stuff Seedrs have got going on. They are the ones that I’m really interested in as it’s hard to find info about this out there, whereas passive investing has now really been done to death I find (and it seems a lot simpler anyway in the first place)
I invested in an seed fund recently, which uses EIS/SEIS tax breaks. It seems like a really good “deal” even though the charges are eye wateringly high compared to passive investing, because of the tax breaks, and because of the chance of much higher returns (along with much greater chance of losing your stash, of course). When I am ready to have another dabble I will definitely check out Seedrs!
Thanks again!